John Deere See Future in Bulldozers

August 13, 2012

Deere & Co. is best known for its mammoth green farm tractors and combine harvesters, but much of its growth potential is in the construction equipment market, taking on Caterpillar Inc. and Komatsu Ltd.

The brutal U.S. summer drought is killing large swaths of the nation’s corn crop, sparking concerns among investors that farmers could delay new machinery purchases.

As the drought intensified in the past month Deere’s shares fell 2 percent. By contrast, shares of Caterpillar, which does not make agricultural equipment, gained 6 percent.

Amid all the bad agriculture news, investors do not give Deere enough credit for its construction business, analysts say. The company expects emerging market s a les of bulldozers, front-end loaders and dump trucks to help double annual revenue to $50 billion in 2018 from $25 billion in 2010.

“I think John Deere is in a sweet spot. To me, the stock is dirt cheap,” said Gary Bradshaw of Hodges Capital, who manages Deere shares for clients and holds the stock in his personal portfolio. “Construction sales will definitely help Deere grow its business, even if their main focus is agriculture.”

The Moline, Illinois-based company’s construction and forestry unit brought in $5.37 billion in revenue last year, roughly 17 percent of total revenue. That more than doubled from 2009 levels, when construction sales only brought in 12 percent of total revenue.

Agriculture remains Deere’s bread and butter, contributing about 80 percent of 2011 revenue. There are also concerns about the impact on construction spending from the slowdown in China’s economic growth, the eurozone debt crisis and the looming U.S. fiscal stalemate.

But Deere’s net income should jump 10 percent each year for the next three years, and its stock’s intrinsic value is 75 percent higher than current levels, according to Thomson Reuters StarMine, which analyzes top analyst opinions. Intrinsic value is a measure of how much shares should be worth when considering expected growth rates over the next decade.

Deere declined to comment ahead of its quarterly earnings release next Wednesday, when it will further outline growth expectations.

THE COLOR GREEN

Deere’s 2011 construction revenue eclipsed the $3.88 billion in construction equipment revenue last year from rival CNH Global NV, which is being acquired by Fiat Industrial , but was well below the $19.67 billion in revenue from Caterpillar’s construction industries unit.

Analysts expect Deere to report earnings of $2.32 per share for its fiscal third quarter ended July 31, according to StarMine, a 37 percent jump from a year ago. Revenue is expected to grow 23 percent to $9.48 billion.

“Agriculture will likely remain three-quarters of Deere’s business in the long run,” said Morningstar analyst Adam Fleck. “But construction is more and more an important part of Deere’s portfolio.”

Analysts say Deere’s success as the world’s largest farm equipment maker and the outsized presence of rival Caterpillar stifles its ambitions in the construction industry.

The color green, part of Deere’s brand identity, coats every piece of farm equipment the company sells. Celebrities such as Ashton Kutcher don Deere baseball caps on top-rated TV shows, giving free advertising.

But the color yellow is also part of Deere’s stable. The color is usually considered by many as Caterpillar’s trademark, reflecting its success in defining the market and Deere’s challenge as it works to boost construction equipment sales.

“Deere is no slouch in the construction business, but certainly they don’t have the pricing power or the market strength to be able to push around the market like Caterpillar can,” said Fleck, the Morningstar analyst.

“I think that’s reflected in the fact that Deere’s construction equipment is yellow. They had to conform to the norms, which were set by Caterpillar, rather than set their own way.”

Not every Caterpillar product is more expensive than rival Deere machines, but Caterpillar has the ability to boost prices before Deere given its market dominance, Fleck said.

For instance, a new Caterpillar 980K front-end loader in Minnesota was recently priced around $438,000, about 31 percent higher than John Deere’s comparable 844K model.

Most of Deere’s construction sales are in North America, but a rising middle class in Russia, Brazil, China and India is expected to increase demand overseas, analysts say.

“In India and China, Deere will be able to leverage off its already strong brand name in farm equipment,” said Eli Lustgarten, an analyst with Longbow Research.